Apr 09 2010

Should the US Government Debt Rating Be Downgraded? Swap Spread Market Is Saying, Yes!

Posted by Jiro Okochi in General

Strange things are happening in the longer end of the USD LIBOR swap curve where USD Swap rates were trading below US Government bond yields at the end of March. In other words, swap spreads were negative for the first time in the 25+ years of the interest rate swap market.  LIBOR, or the London Interbank Offered Rate, is an index based on the interest rate at which banks lend to each other in London in a particular currency and calculated from a panel of major banks http://www.bbalibor.com/bba/jsp/polopoly.jsp?d=1645.  As most of the banks polled are of Single A or higher in credit rating, the LIBOR flat swap curve implies approximately a Single A bank credit curve, so a AA corporate should trade at LIBOR less a spread and maybe a weaker single A corporate should benchmark itself at slightly above LIBOR when looking to swap its own debt using the LIBOR swap market. 

As the US Government credit rating is AAA, it has typically been trading at a lower yield than the equivalent USD Swap rate and as a spread over US Treasuries, so the USD Swap rate was always positive.  The chart below depicts the historical data of 10-year Treasuries vs 10-year Swap rates, which over the last five years averaged 46 basis points and peaked almost at 90 basis points during the height of the financial crisis.   The spread flirted with being 0 at the start of 2009 when the world was unsure whether the US was headed for a double dip or worst Depression 2.0. Since then, however, the economic picture has gradually improved, yet last month the spread broke the 0 floor and dropped as low as -9 basis points. 

What is the swap market trying to tell us?

It could be a supply and demand factor due to a lack of new issuance—banks not lending or borrowers not borrowing—or due to the lack of corporates paying fixed in a steep yield curve that has forced down swap spreads.  It’s probably a stronger reflection of the large debt load the US government needs to issue to pay for the bailouts and programs and a disconnect with the LIBOR markets where banks have access to liquidity and do need to lend to each other.  Whatever the reason, something needs to give on the credit side, where either the swap curve should be reflective of BBB banks and the swap yields should be higher than the expected rise in US government yields or probably the reality that the US government should be downgraded to AA to reflect the huge and ever-increasing budget deficit and debt issuance, at least that is what the USD swap spreads are saying.  The other time swap spreads were negative in a G7 currency was when Japanese swap spreads were negative to JGBs around the end of 2001—which was around the time S&P cut Japanese credit  a notch to AA (http://www.nytimes.com/2001/11/29/business/s-p-cuts-credit-rating-of-japan.html?pagewanted=1).